9/13/2009 @ 12:26PM

Lehman's Lesson

A year ago
Lehman Brothers
filed for bankruptcy after an offer from
Barclays
Bank to acquire the firm without government assistance fell through because the Fed would not guarantee Lehman’s open trading positions for a temporary period so the deal could get done. The Fed didn’t have authority to take Lehman’s assets as collateral, it said, and the Treasury strongly concurred, believing that markets had prepared themselves for Lehman’s demise. But they hadn’t. To the contrary, the last-minute intervention to assist
JPMorgan Chase
in acquiring Bear Stearns four months earlier, justified on the grounds that Bear Stearns was too big to fail, caused investors to believe that Lehman, a larger firm, would have to be rescued too. Instead, the government reversed itself, wrong-footing just about everyone. Letting Lehman go was a mistake.

The event triggered a three-month market panic the likes of which no one living can remember, shutting down the interbank credit market and the commercial paper market and causing an instant run on money-market funds, and on the debt and stock prices of other large banks and investment banks. Within days of Sept. 15,
AIG
had to be rescued by the Fed, Merrill Lynch was sold to
Bank of America
;
Goldman Sachs
and
Morgan Stanley
were converted into bank holding companies; and the government was on its knees before Congress pleading for a $700 billion Troubled Assets Relief Program and predicting dire consequences if it was denied or delayed.

Meanwhile, just about all the resources available to the Fed were used to shore up terrified financial markets, which had gone into free fall. Liquidity in credit markets had disappeared, the stock market dropped 38% by late November and volatility had quadrupled. By the end of the year, the Treasury and the Fed committed several trillions of dollars to the rescue of the system, perhaps 500 times more than the cost of guarantying Lehman’s trading book.

In time the system was stabilized and returned, more or less, to normal but with many of its leading players injured, sidelined or playing now for different teams. Such things have happened in panics before, many times, but the scale and violence of this one was breathtaking. It was certainly scary, and has been followed by an extensive laundry list of reform proposals from the U.S. government, other governments, and an endless list of interested parties and commentators.

Over the last 30 years the world has moved away from central planning and other forms of government control to embrace more liberal economic policies that have relied on market prices and a limited role for government. These policies, which were suddenly adopted by half the world’s population in the 1990s, resulted in a continuing chain of deregulation, privatization, structural reforms and increased economic growth for most of the world, especially emerging-market and former communist countries. With this change has also come an increase in trade, investment, competition, innovation and risk-taking, especially in financial markets. It also produced soaring market values over time, despite many market corrections.

At the end of 2007 the market capitalization of all stocks and bonds in the world was $144 trillion (up from $27 trillion in 1990, an 11% compounded growth rate). Global market capitalization in 2007 was 10 times the size of the GDP of the United States; a vast pool of capital that can move freely at will in response to the usual market motivators, greed and fear. By the end of 2008, global market capitalization had dropped by $25 trillion as the crisis triggered by the Lehman bankruptcy spread globally at electronic speed. It wasn’t just American investors selling into the crisis.

The real question facing global economic officials now is not what to do about bankers’ bonuses, or derivatives or hedge funds–none of which caused the global crisis–but how to put some kind of restraint on the capital pool to prevent it from cycling indefinitely from bubble to bust with increasingly catastrophic consequences.

Reducing systemic risk so government interventions are not necessary is what has to be done. And it is essential that this be done effectively, quickly and globally–we are already more than a year into this crisis and Congress has not yet taken up the Geithner proposals, and when it does, we are told to expect resistance. It shouldn’t be that hard: There are probably only 30 or 40 financial firms in the world capable of damaging the whole system, and these need to be constrained. The firms can have the choice of shrinking themselves or of learning to live with tough restrictions on capital, leverage and liquidity.

Existing law gives regulators a lot of power to restrict banking activity, but that power hasn’t always been used.

Congress passed a law in 1989 after the last banking crisis (the Financial Reform Recovery and Enforcement Act) requiring bank regulators to be tougher and to intervene earlier to prevent the build-up of bad loans in the system, but it didn’t seem to apply to
Citigroup
or Wachovia. Congress also passed the much acclaimed Sarbanes Oxley bill in 2002 after the collapse of Enron and WorldCom to improve public accounting and corporate governance. This didn’t seem to cause their boards of directors to slow things down or to query risk-management capabilities at Merrill Lynch or AIG. Where were the protections of these existing regulations when we needed them in 2005-2007?

Modern Wall Street is today the global capital markets industry. The industry provides great value to the world, but that value is questioned when financial crises wreak havoc on the real economy twice in a decade. To endure, the ability to moderate these crises must be developed. Governments have the power to do this, but governments are not always very good at writing the laws that are needed or at enforcing them. So, the principal lesson from Lehman experience has to be that one should not rely on regulations, enforcement or expected interventions to protect their interests. Those who want to survive will have to learn how to protect themselves. If everyone learns this lesson, the system will survive longer.

Roy C. Smith is the Kenneth Langone Professor of Finance and Entrepreneurship at the Stern Business School, at NYU. He is a contributor to a Stern School book on the financial crisis, Restoring Financial Stability(Wiley, 2009).